IRA Restrictions – A Guide to Your Best IRA

by Neal Frankle, CFP ®

The world of IRA restrictions is a complicated one.

ira restrictions

But you can use those restrictions as a guide to finding the best retirement account available. Let’s take a trip down IRA Road…shall we?

Traditional IRA

This is the standard IRA. It’s also known as the traditional or deductible IRA. If you have taxable earned income, you are eligible to contribute to this plan.

In 2010, the contribution limit is $5,000 ($6,000 if you are 50 or better). When you make a contribution, you deduct that amount from your taxable earned income, reducing your taxable income. That’s the reason most people have traditional IRAs – for the tax write-off. Even though that’s why we make the contribution – that’s not the real payoff.

The real benefit of any IRA is that it’s a forced savings. In my experience, by the time we retire we have most of our liquid assets in our retirement accounts for exactly that reason. It’s money that is tough to spend. Often, that money creates wealth for both you and your heirs. (Read IRA Beneficiary Rules).

You can invest your IRA – any IRA – any way you want.  You can also open an IRA account until April 15th of the following year.  So for your 2010 tax return, you can open and fund an IRA up until April 15th 2011.

While the money is in the traditional IRA it grows and you don’t have to pay any taxes on it. You only pay tax on the money you withdraw as you withdraw it. (Make sure you understand IRA withdrawal rules.) But you pay income tax (as opposed to capital gains) on every dime as you withdraw.

Let me give you an example.

Let’s assume that over the years, your total contributions are $100,000. But because the market tumbles by the time you retire, the account drops to $25,000. You lost $75,000 but you don’t get a write-off for the losses. No, sir. You will pay full income tax on the $25,000 as you withdraw it.

You may withdraw the money penalty-free starting at age 59 ½ and you must start making withdrawals at age 70 ½. Once you reach age 70 ½, you can’t make any more contributions to an IRA – even if you still work.

Restrictions

a. Income – you have to have earned income in order to contribute.

b. Age – you can’t contribute after 70 1/2.

c. Phaseout – If you or your spouse is eligible to participate in a retirement plan at work, you can still make contributions to an IRA – but you may or may not be able to deduct some or all of those contributions. It depends on your income. Even if you aren’t covered by a retirement plan at work, if your modified adjusted gross income exceeds a certain amount, you may not be able to deduct some or all of those contributions.

Bottom line – The traditional IRA is great if:

a. You have earned income.

b. You contributions are fully deductible and not impacted by the phaseouts.

c. You are in a high tax bracket now and you think you’ll be in a lower tax bracket when you retire.

d. You don’t have other options available at work.

Roth IRA

The Roth IRA has the same contribution limits as the traditional IRA.

The Roth IRA grows tax-free and allows you to withdraw the money tax-free too. SWEET! However, in order to make those tax-free withdrawals you must be older than 59 ½ and have owned the account at least five years.

You can make contributions as long as you’re alive – as long as you have earned income. There are no age restrictions. To make things even more attractive, you never have to take required minimum distributions from your own Roth. Your Roth beneficiary also has some very attractive benefits. Finally, even if you have a plan at work, you can still contribute to your Roth.

The only downside is that your contributions are not tax-deductible.

Restrictions

Income – In order to make contributions, you have to have earned income. But if you have too much income, you can’t contribute to the Roth. For 2010, eligibility for Roth contributions is phased out between adjusted gross income (AGI) of $167,000 and $177,000 for joint filers and between $105,000 and $120,000 for singles.

Bottom line – The Roth is very good for young people who have earned income – assuming they don’t change the law. It’s a pretty safe bet that tax rates will rise so if they don’t change the rules a Roth is a great vehicle for young tax payers. The best IRA investments for Roth accounts tap into long-term growth – and that means equity growth.

Having said that, I’d max out on the tax-deductible traditional IRA and then turn to a Roth. I’d rather have a tax deduction in the hand than a promise by the government for future benefits. Keep in mind that any amount you contribute to a traditional IRA reduces the amount you can contribute to a Roth.

SIMPLE IRA

If you are in business for yourself with 100 employees or less, a SIMPLE IRA might be a great fit. They are easier and cheaper than 401k plans. Typically, if the employee makes a contribution, the employer has to match it (up to 3% of pay).

You can contribute up to $11,500 in 2010 and you can bump it by $2,500 if you are over 50 years of age.

Restrictions

Either the employer offers this plan or she doesn’t. You usually can’t force the issue.

Bottom line – If your employer offers this plan, get involved and max out your contributions before you worry about any other plan.

SEP IRA

These plans are less popular with employers for one simple reason: your employer makes the contributions for you. You don’t put in a dime. The contributions can’t exceed $49,000 in 2010 or a maximum of 25% of the employee’s compensation. The contributions to the plan are tax-deductible and, like the traditional IRA, all withdrawals are taxable.

Restrictions

You can’t force your employer to make this plan available either.

Bottom line – If your employer offers this plan, send her flowers and name your child after her – even if it’s a boy.

Spousal IRA

If you are a stay-at-home dad or mom, I have some great news: you can still have an IRA. The contributions are the same as the traditional IRA and you make contributions even if you have no earned income.

Restrictions

The working spouse’s income determines how much (if any) you can contribute to a Spousal IRA.

Bottom line – If you have the cash to contribute to this plan, do it. It is a great tax deduction and a way to force yourself to save for the future.

Rollover IRA

If you have a 401k or other retirement plan that was offered at work, you may be able to roll it over to your own IRA. This is known as a rollover IRA.

Once you do the rollover, you can make contributions to it as if it’s a traditional IRA with the same limits. ($5,000, $6,000 if you are 50 or older.)

Restrictions

Once the money from an employer plan is rolled over to Rollover IRA, you are subject to the same restrictions as the traditional IRA.

Bottom line - The only choice you have here is whether or not to keep the money at your former employer or do a tax-free IRA rollover. That has pros and cons and is the subject of a post in and of itself. The argument for is that you have much more control and flexibility. The argument against is that with an employer plan, you may have more favorable distribution options.

In most cases, I favor the IRA rollover.

Final Bottom Line

If you have a choice, it’s almost always best to first max out on your contributions to an employer plan. This is because they typically offer some matching. Even if they don’t, the employer plan is the safer bet. This is because you might not be able to make deductible contributions to an IRA if you or your spouse have a plan at work.

I personally like the deductible plans rather than Roth because I have no idea what the government is going to do in the future and I like having the deduction now. Perhaps this is short-term thinking. Anyway, that’s why I’d only go for the Roth if I didn’t have a deductible plan available.

What kind of plan do you have? Why do you participate in it and not some other plan?

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{ 5 comments… read them below or add one }

Les May 22, 2012 at 5:46 PM

I decided to do a Rollover IRA several years ago because
I was changing jobs every 3-5 years and didn’t want my IRA
administration to be held by a former employer. However
my current company offers a 403b with a certain matching
amount. Can I have both retirement accounts. The Rollover is
very well managed, but I do want to take advantage of the matching
funds.

Reply

Neal Frankle May 22, 2012 at 7:40 PM

Yes you can have an IRA and a 401k. No problem.

Reply

Thisiswhyubroke.com! May 25, 2010 at 10:11 PM

I agree! Dont pass up free money when your employer is offering you matching. I can’t understand why people don’t take advantage of this by any means necessary.

“Its time to stop paying your debts. Yes, you.”

Reply

Nunzio Bruno May 25, 2010 at 10:43 AM

Those “Bottom Lines” were great summations. The world of IRA’s is def not an easy one and with so many people taking their IRA’s into their own hands it can get pretty volatile. Your end point about maxing out contributions to employer sponsored plan is important, you don’t want to miss out on any kind of matching programs! This is a good post for employers who thought that providing plans for employees would be too difficult or they were too small.

Reply

Erica May 24, 2010 at 12:35 PM

I’ve been wondering about restrictions on multiple retirement accounts. I’m young and I max out my Roth IRA every year. I’m self-employed and in a low tax bracket, but I may bump up next year because I’ve had more work. I’ve saved more than half my income so far this year.

Would I be allowed to open a second retirement account, with the hope that a tax-deductible contribution would bring me back down a bracket? Which account would be best? Would this be a dumb idea, since I wouldn’t be able to use that money (penalty-free) for 30 years?

Reply

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